Description

Dart has been written up before on VIC, including twice over the past couple of years: avalon216 wrote a well timed note ahead of the recent capital raise, and punchcardtrader provided a detailed analysis of their routes and pricing in 2019.

Thesis

Dart Group (soon to be renamed Jet2) is the UK’s fourth largest airline and second largest package holiday provider. Jet2 has demonstrated high, consistent and largely self-funded organic growth over two decades. Notably, in the past ten years, their share of UK holiday passengers flown has increased from 4% to 12.5%, while they have grown their package holiday business from a start-up in 2007 to 16% of the market in 2019. This has been achieved through pairing a low cost structure with exceptional customer service.

Today, Jet2 is positioned to comfortably survive the ongoing disruption, emerge with a stronger balance sheet than pre-Covid, and accelerate market share growth after the lifting of travel restrictions. The shares currently trade at 7.9x our FY23 (CY22) EPS estimate, and we expect a rerating to 11x (1050p), offering 40% upside over the next year as the focus shifts to recovered earnings and a strong summer of 2021. Our two year out upside target is 1500p as the market again will start discounting a long runway of double digit revenue growth and the improved earnings quality from an increased proportion of package holiday passengers.

Management

Founder and current Executive Chairman Philip Meeson initially purchased Jet2’s predecessor, an air freight and distribution business, in 1983. He listed the business in 1989, and the shares have since generated a total return of c.15% annualized. The low cost airline, Jet2.com, was started from scratch in 2002, followed by Jet2holidays (package holidays) in 2007.

Meeson is known for his relentless dedication to the business (still works full time), focus on the customer experience, sometimes combative approach, and a love of planes: he used to be in the RAF and later was an aerobatics pilot. Now aged 72, Meeson still owns 30% of the business, and he generally sells a small portion on a semi-annual basis.

Given Meeson’s age, a strong CEO is especially important: Stephen Heapy, a travel industry veteran, was initially brought in to run the package holiday business in 2009 (shortly after start-up) and has since taken increasing responsibility for the airline. The performance of package holidays under his tenure has been stellar, showing consistent profitability alongside revenue growth always above 20% (until the current year). Heapy has now been appointed CEO of the whole business following the sale of the small distribution business.

The team has been conservative with guidance, has used modest leverage, and are paid relatively little. However, they communicate and disclose information to investors sparsely.

Business

Jet2 focuses, almost exclusively, on outbound tourism from the UK to Europe. Historically, the focus was the North of England to beach locations, but their bases have now broadened across the UK, and destinations include city breaks and ski destinations. 

We like this business because it is a combination of a well-run, low-cost airline and an even better asset-light budget package holiday operator. Controlling the airline experience and ensuring seat availability and on-time travel is important as it book-ends the holiday. Owning the entire customer journey to ensure a positive experience leads to repeat business and is the key to pricing power, strong ROEs and growth. 

Historically, results have been weighted toward the more volatile airline business but we believe that by CY22 the package holiday business will be approximately half of the operating profit after excluding underlying airline profits (rough estimate as costs are not broken out fully by the company). From the customer’s point of view, booking a packaged tour with Jet2 provides convenience, value, and a wide selection of curated destinations. Having a positive family experience and associating it with a trusted brand ensures a loyal and expanding customer base, making for a compounder business.

From start-up in 2002, the business has been online and is not burdened by a physical retail presence like Tui (no.1 in package holidays) and the now-defunct Thomas Cook (no.3 last year in package holidays). The airline operates a low cost model, using older planes (refurbished to a consistent standard) and largely working out of 2nd tier UK airports. They have expanded cost-efficiently at busier airports such as London Stansted and Birmingham through opportunistic slot purchases, most recently from Thomas Cook’s bankruptcy in late 2019. Their ticket-only pricing is approximately in line with other low cost carriers when in direct competition; however, many of their routes are specialist (e.g. Leeds to Murcia, Spain) and have no or limited overlap. This was covered in detail in punchcardtrader’s write up.

Superior customer experience is at the core of the company and has been key to their market share gains. As mentioned above, this is especially important for the package holiday business, where repeat customers improve profitability through reduced price sensitivity and lower average customer acquisition costs. In addition to culture and training, Jet2 maintains approximately 8% of their fleet on standby to respond to disruption and reduce delays (the cost of which is reduced by use of relatively old aircraft). This creates a key competitive advantage, that is hard to replicate since it’s costly, and is evidenced by online customer reviews (Tripadvisor, Skytrax, Trustpilot, etc.), which are markedly better than other major UK airlines. Their recent response to Covid disruption has also won praise. On the critical issue of timely customer refunds, they have come out far ahead of their primary competition in reports by moneysavingexpert.com and which.co.uk.

Jet2’s market share track record has also been supported by the weakness of their competition. The decline and eventual bankruptcy of Monarch Airlines in 2017 contributed to a jump in market share of holiday passengers from 7% in FY2017 to 12.5% in FY2020 and 9% to 16% in package holidays. The September 2019 bankruptcy of Thomas Cook (no.3 package holiday provider) was set to accelerate Jet2’s growth in the summer 2020 but has been temporarily overshadowed by Covid disruption. This catalyst will very likely start coming through from summer 2021 on. Thomas Cook was significant at 66% the size of the DTG package holiday business and approximately 40% of total Jet2 air passengers.  DTG is the natural home for Thomas Cook customers with a similar offering in terms of service.

Going forward, Jet2’s key competitors are Ryanair, Tui, and Easyjet. Ryanair is a formidable competitor on price, and unlikely to cede share, but has further widened the brand/customer experience perception gap through delaying refunds during Covid. Tui is facing severe balance sheet pressure and secured a bailout from the German government, still maintains a legacy retail presence, and is very likely to act as a market share donor for the foreseeable future (they have started cutting a substantial number of UK retail branches). Easyjet is under moderate balance sheet strain and is cutting future aircraft deliveries. They recently decided to leave Stansted (small for them), which is a benefit for Dart as it overlapped with Jet2. Easyjet is also attempting to expand their package holiday business, but have found this difficult in the past. If successful, this will be a small negative with relatively low overlap to Jet2 routes. Pure online travel agents (On The Beach, Love Holidays, Expedia) are also a feature of the UK package holiday market. They have been successful, but are periodically challenged by a lack of vertical integration in times of constrained seat supply (likely the case in summer 2021) and a lack of control of the customer experience (saw delayed refunds during Covid as dependent on the underlying airlines).

Overall, we forecast sustained annual market share gains of just under 1% in holiday passengers and 1.5-2% in packaged holidays, following an initial bump from Thomas Cook gains. This is similar to history, but a reduction in percentage passenger growth as the base becomes larger.

Catalysts

Rerating is likely to be catalysed by the return to a more normal operating environment (likely before summer 2021). This will shift the focus from short-term travel disruption to Jet2’s continued market share gains, low leverage and valuation.

Assuming limited travel disruption, we anticipate strong pricing and volumes in the key summer 2021 season, due to a combination of pent-up demand and constrained supply, with share gains from Thomas Cook also coming through. Management are currently planning to fly a schedule in line with summer 2019, although load factors are currently tracking ahead of last year. We think it is likely they will add capacity over the next six months, possibly after seeing the bookings in January, when many customers plan their summer holidays.

Risks

Near term, a second Covid wave could severely damage the outlook for winter travel. However, this is well within the range of existing expectations and management’s planning. The far more important summer season appears likely to go ahead in 2021. If heavily disrupted, Jet2 will have adequate liquidity but need continued covenant relief, and will potentially be reliant on government loan programs.

With the recent capital raise, Jet2 secured covenant relief for their semi-annual test in September. However, although management expressed confidence on securing longer term relief, this remains an unknown and management provides minimal disclosure on the details. We think they are unlikely to have difficulty securing relief for the March 2021 covenant test given the low overall leverage and Jet2’s excellent liquidity position. We expect their cash (excluding customer deposits/deferred revenue, which they are not required to ring-fence but in practice treat as separate) to bottom out at approximately £350m with peak working capital outflow. Alongside an undrawn government backed facility of £300m, they have a large buffer (over 12 months of no-flying from today can be supported). Fortunately, the company has no new aircraft commitments, which allows for flexibility and the possibility of picking up cheap planes going forward.

Demand for holidays abroad in the UK is cyclical: nationwide passenger numbers fell 9% in 2009, followed by a slow recovery. A prolonged recession could suppress airline pricing while supply continues to adjust. Jet2 may be able to accelerate share gains from weaker competitors in this environment, and have a customer trade-down benefit to value holiday packages, but the earnings run rate would be significantly lower.

Valuation

We expect the shares will re-rate over the next year to 1050p, 11x our estimate of FY23/CY22 EPS, in line with Jet2’s historical trading range, as the strong position of the business post travel restrictions becomes clear. Net debt (not including customer funds/deferred revenue) will run below 1.5x EBITDA, which is lower than their pre-Covid average. 11x P/E appears low set against sustained double digit revenue/EPS growth, but this growth requires approximately half of earnings to be reinvested (excluding the cash inflow from customer deposits), and investors are reasonably wary of the cyclicality/uncertain pricing of the airline/package holiday industry. Our upside price is 1500p,13x our CY23 EPS. 

Margins should bounce back faster than during a normal recession due to pent-up demand and rapid industry supply cuts, but we forecast margins to remain modestly below the strong FY16-20 levels for the foreseeable future. This is a key area of uncertainty, largely driven by volatile industry supply/demand balance. Over time, the margins have become steadier as the package holiday business has increased as a proportion of passengers and has added a relatively stable layer of profitability.

Against peak EPS of 110p (adj. for capital raise dilution and distribution divestiture), Jet2 trades at 6.8x. Notably, the peak EPS does not include a benefit from their Thomas Cook share gains, which would have been felt in summer 2020. For context, other successful low cost European airlines (without the package holiday business) Ryanair, EasyJet, and Wizz trade at 10x, 5x, and 13x recent peak EPS. Jet2 has historically grown faster than these businesses and will likely grow faster than Ryanair and EasyJet going forward, while Wizz may grow faster. Jet2 saw less earnings volatility through the 2009 recession than Ryanair or EasyJet and has margins almost at Ryanair’s level (excluding the pass-through of accommodation costs) due to the additional profit layer from package holidays.

Catalyst

• Removal of travel restrictions (ahead of summer 2021).
• Strong volumes/pricing in summer 2021 and likely upgrades to their flying schedule.
• Continued share gains and double digits growth in CY22+ as normal travel patterns resume.